Fitch Rates Russian X5 Finance's RUB5bn Bond 'BB-'
X5 Finance LLC is a fully consolidated non-operating subsidiary of X5 Retail Group N.V.
Similar to two other traded bonds of X5 Finance LLC, which Fitch also rates 'BB-', the new bond only features a suretyship from a holding company X5 Retail Group N.V. (X5). Therefore, Fitch considers these bonds structurally subordinated to other senior unsecured obligations of the group, which are at the level of operating companies.
Fitch has assigned the bond rating one notch below X5's Long-term local currency 'BB' IDR (Stable Outlook) as prior-ranking debt exceeds 2x (estimated at 2.4x in the 12 months to September 2015) of group EBITDA and we expect the debt mix to remain unchanged over the medium term.
KEY RATING DRIVERS
Below-average Recoveries for Unsecured Bondholders
The bond rating reflects below-average recovery expectations in case of default. We have applied a one-notch discount to the senior unsecured rating compared with X5's Long-term IDR as prior-ranking debt constitutes more than 2x of group EBITDA - the maximum threshold under Fitch's criteria before triggering subordination of unsecured creditors.
Leading Multi-Format Retailer in Russia
The rating is supported by X5's strong market position as the second-largest food retailer in Russia, which is one of the top-10 largest food retail markets in the world. The business model is supported by own logistics and distribution systems and multi-format strategy. Despite increasing competition from other large retail chains in the country, Fitch believes that X5 is well positioned to retain and improve its market position in the medium term. The ratings also factor in X5's strong bargaining power over suppliers due to its large scale and growing geographical presence across Russia's regions.
Subdued Consumer Sentiment
For 2016, we expect X5's operations to remain resilient to subdued consumer sentiment due to the company's focus on the defensive discounter format and better price proposition in comparison with traditional stores and small retailers. This is despite our expectation that like-for-like (LFL) sales growth will decelerate from a strong 15% in 9M15 as consumers keep on trading down and footfall migration to discounters is slowing.
Strong Operating Performance
In 9M15 X5 demonstrated healthy revenue growth of 28%, while maintaining stable gross and EBITDA margins. We expect sales growth in 4Q15 and 2016 to be supported by fast-selling space expansion, on-going store refurbishments and improved value proposition. Despite pressure from potential margin sacrifices and higher lease payments, the EBITDA margin is projected to remain stable thanks to high price inflation outpacing growth in staff costs and other administrative expenses. We note that X5's current and expected levels of EBITDA margins (9M15: 7.2%) remain strong compared with Fitch-rated western European food retailers.
Despite X5's accelerated store roll-outs, we expect only marginal changes in leverage metrics, with FFO adjusted leverage staying around 4.0x-4.5x in 2015-2017 (2014: 4.5x), which is strong relative to the 5.0x 'BB' rating median for the sector. This is based on our projection that strong growth in revenue and EBITDA will balance higher capex. Although shortening payables days and hence outflows under working capital remain a risk, we expect cash flows from operations should be sufficient to cover 50%-80% of planned capex in 2015-2016.
Weak Coverage Metrics
We expect the FFO fixed charge coverage ratio to remain weak for the ratings, at around 1.6x-1.8x over 2015-2017, as a result of higher operating lease expenses and the high interest rate environment in Russia. However, this is mitigated by the partial dependence of leases on store turnover, favourable lease cancellation terms and the high share of fixed-rate debt.
Financial flexibility is also supported by limited FX risk as X5's debt, revenues and most of costs, with the exception of certain lease contracts and minor direct imports, are rouble-denominated.
Negative: Future developments that could lead to negative rating action include:
- A sharp contraction in like-for-like sales growth relative to close peers.
- EBITDA margin erosion to below 6.5% (2014: 7.2%).
- FFO-adjusted gross leverage above 5.0x on a sustained basis (2014: 4.5x).
- FFO fixed charge cover significantly below 2.0x on sustained basis if not mitigated by flexibility in managing operating lease expenses, including alignment of leases with store revenue.
- Deterioration of the liquidity position as a result of high capex, worsened working capital turnover and weakened access to local funding in the face of rouble bonds maturing in 2016.
Positive: Future developments that could lead to positive rating action include:
- Positive like-for-like sales growth comparable with close peers together with maintenance of its leading market position in Russia's food retail sector.
- Ability to maintain the group's EBITDA margin at around 7%.
- FFO-adjusted gross leverage below 3.5x on a sustained basis.
- FFO fixed charge coverage around 2.5x on a sustained basis (2014: 1.8x).
At end-September 2015 unrestricted cash of RUB4.8bn, together with available undrawn committed credit lines of RUB36.8bn, were insufficient to cover RUB44.2bn short-term debt. However, RUB31.2bn of debt was related to short-term revolving credit facilities, which we expect to be extended upon maturity. We believe X5 retains good access to local funding thanks to the company's large scale, non-cyclical food retail operations and strong recent operating performance. In addition, the new RUB5bn bond issuance, which is aimed at refinancing short-term debt, should have strengthened the company's liquidity position.